Pick a term that is bandied about the most but understood the least and chances are it will be ROI, return on investment. Before we go any farther, let’s say a few things about ROI.

ROI is a financial term with an actual financial formula. There is no substitute for it and there are no factual, intelligent ways to weasel around it. Expressions like “return on influence”, “return on engagement”, and “return on conversation” are largely invented terms by people who don’t know how to calculate ROI.

That said, ROI is not the ultimate measure of marketing performance. ROI is an objective metric (an endgame metric that tells you if you’re there yet) only if cost containment is a priority for your marketing. If you are in a growth mode with an objective of capturing significant market share, ROI can actually be a hindrance to your marketing efforts because over-focus on it will prevent you from taking short-term losses in exchange for long-term potential gains.

That is ROI. It’s a deceptively simple formula. The reason why it’s so deceptively simple is that there are a lot of components in each of the two areas.

Determining income earned from marketing efforts requires the use of a good CRM that allows you to track what marketing methods actually result in sales, and what the revenue of those sales is. For example, let’s say you sell chewing gum. To the best of your ability, you need to be able to track exactly how much gum you’ve sold to consumers at what price, by marketing channel. The last part is the catch. It’s easy to figure out how much gum you’ve sold, but much harder to figure out what marketing channel drove those sales. Online is relatively simple – using tools like Google Analytics to track checkouts at a virtual store makes that fairly straightforward. Offline is trickier and requires things like surveying and statistical sampling in order to accurately assess why someone bought a pack of gum.

Income can be even trickier to determine if it’s decoupled from marketing, as is often the case with wholesalers and resellers. If you manufacture alkaline batteries like Duracell or Energizer, there’s a good chance you use a distributor or reseller like a Walmart or Target to resell your goods. As a result, your marketing efforts to build your brand are decoupled from the actual transactions because someone else is handling the sales – and as a result, all of your brand-building effort may be for naught if a reseller fails to display your products effectively. One of the few methods that gets around this problem to some degree is coupon redemption. If a manufacturer issues a coupon, they can get an actual idea of a channel’s income generation potential by tracking how many coupons were issued vs. how many were redeemed from that channel.

The expense side of marketing is also fraught with danger, especially in fields like social media. Almost no one tracks the single largest expense in social media: time. Time is not free. Time has never been free. How much you spend in any marketing channel isn’t just a question of money leaving your bank account or corporate credit card, but time spent as money.

Here’s an example of determining time spent as money. Let’s say you’re in marketing and you earn $50,000 per year. The effective number of working hours you have per year is 52 weeks x 40 hours per week, or 2,080 hours. Your effective hourly pay, then, is $24.04 per hour. For every hour you spend on Twitter, Facebook, Quora, etc., you are effectively investing $24.04 of time as money in that marketing channel. Suddenly, channels like social media get very expensive.

So let’s put the two sides, income and expense, together in an example so that you can see what marketing ROI looks like.

Let’s say you decided to advertise using Google’s Adwords pay per click advertising. Let’s say you spent $500 in cash and 5 hours of your time (at a $50,000/year salary) to get Adwords up and running, and in turn, you earned $1,000 in sales of, let’s say citrus-scented headphones.

This is an excellent ROI. It states that for every dollar spent, you earned the dollar back plus 61.24 cents. Any business would be very pleased with that ROI and would likely ask you to invest a little more time and a lot more money if that result remains consistent.

Let’s try another example for the same person at the same company. Let’s say you’ve decided that Facebook is the hottest thing since sliced bread and you’re going to avoid outlaying cash on your Facebook efforts. You set up a Fan Page for your citrus-scented headphones, take 80 hours to set it up, administer it, manage the community, do outreach, etc. but you spend no money on it and you manage to sell $1,000 worth of those strange headphones. You’re feeling good about yourself – this social media stuff works, right?

Do the preparation math:

Income: $1,000

Expense (cash): $0

Expense (non-cash): $24.04 x 80 = $1,923.20

Total Expense: $1,923.20

The ROI formula shows $1,000 – $1,923.20 / $1,923.20 = -48% ROI. Uh oh. When you account for time spent as money, Facebook (in this example) is a money-loser. For every dollar of time you invest in it, you’re losing 48 cents.

This is where it’s decision time for you as a marketer.

Remember, if cost containment isn’t a primary goal, ROI isn’t the correct metric to be focusing on. If you’ve made the conscious and strategic decision to take a financial loss (in cash and time spent as money) in order to grow a long term opportunity, then this ROI of Facebook for citrus-scented headphones may be acceptable. However, if cost containment is a primary goal for your marketing department, you have to make the decision whether to adjust your Facebook strategy or cut it out and stop your losses.

Ultimately, ROI is just one way to measure marketing’s performance, but it’s one of the least well-understood ways of doing so. By walking through this calculation, you’ll realize just how difficult it is to calculate with great precision and how meticulous you must be in your tracking methods in order to capture even moderately good quality data. If you can do that effectively, ROI is yours to analyze, but if you can’t because of organizational structure or operational issues, then you’ll need to forego the use of ROI as a marketing metric.

Glad to see that the marketing ROI conversation is continuing. I am hoping you can give me your opinion on something.

It seems that there are several ROI formulas floating around and yours is the third I have seen in the past few weeks. Along with the challenge of not being able to define what marketing actually is, do we now also have the same challenge when it comes to defining how to calculate ROI properly?

You state: “ROI is a financial term with an actual financial formula. There is no substitute for it and there are no factual, intelligent ways to weasel around it.” (You share that the ROI formula is: Income – Expense / Expense.)

I agree. However, isn’t it understandable that when marketing experts cannot provide unified definitions for ROI (and marketing), others will make up and sell (internally or to clients) their own variations of both?

Heck, we only need to Google Marketing ROI, Accounting ROI and Social Media ROI to get a bunch of different ROI formulas.

I recently wrote a post on calculating ROI and used the ROI formula found in two marketing textbooks that spanned a publishing range of over 15 years. The formula was the same in both books, which led me to believe that it is the accepted accounting formula taught to marketing students.

As you can see, the formulas we both shared are not similar. Maybe there are substitutes, then?
😉

While your formula simpler and easier to use, my question for you is how can marketing professionals come together on what is the correct ROI formula?

Do we rely on marketing textbooks? Do we rely on standard accounting practices? Do we rely on what bloggers write? Or… does it only what our CMOs/CFOs require?

Thanks for taking the time to share your thoughts.

Cheers,
Beth Harte
@bethharte

http://www.ChristopherSPenn.com Christopher S. Penn

The math on that formula is identical to mine. NP/S * S/I = NP/I, where NP is Income – Expense (net profit) and I is effectively the same as expense. The S in sales cancels itself out.

http://www.serengeticommunications.com/ bethharte

Chris,

This is exactly part of the problem. I shared what Etzel, Walker & Stanton (marketing text #1) and McCarthy & Perreault (marketing text #2) define as marketing ROI and yet, you changed the equation.

They clearly state that:

Calculated as (Net Profit/Sales) * (Sales/Investment) where the first equation addresses the rate of profit on sales and the second equation addresses the rate of capital turnover. Net Profit takes into consideration gross profit minus overhead such as marketing expenses (i.e. salaries, vendors costs, campaign costs, etc.), taxes, etc. and Investment only includes marketing assets & sales volume (not campaign expenditures) and sales figures do not cancel out.

(Their words, not mine.)

According to Etzel, et. al., sales figures do not cancel out because they are addressing two different calculations: The rate of profit on sales and sales volume/assets managed (which is found on the balance sheet).

So, back to my original question… who should marketers believe? As a marketer, should I believe and rely on textbooks in their 13th edition or you or Wikipedia or a social media gurus?

The on-going problem is that there is theory (or defined calculations) and reality… and they never tend to be the same. Unfortunately, I don’t think any of us will ever agree on what marketing is (or should be today) and how to calculate ROI.

http://www.serengeticommunications.com/ bethharte

And to your point on Facebook… Yes, this equation is not practical. No doubt about that…there are too many parts of the equation that marketers might struggle to get numbers for. Especially campaign leads that led to sales. (Gee, we could only wish that one campaign closed tons of sales… So far from the norm in B2B marketing.)

http://www.ChristopherSPenn.com Christopher S. Penn

I’d agree that theory and reality rarely align. The very basic I-E/E formula is what I use on a day-to-day basis at Blue Sky Factory and my own work. The question I’d ask in that formula is why would rate of profit on a sale be substantially different than sales volume? Because you’d be sitting on unsold inventory and that would count against you? If so, that to me is an operations problem moreso than a marketing one. If you are examining overall return on investment that encompasses all aspects of the company, I think you could make a case for Etzel’s formula, but when you scope down to marketing, it makes less sense to me.

http://www.serengeticommunications.com/ bethharte

Agreed, simpler is better for marketing ROI. This formula makes sense for B2B marketers (product-focused, like high-tech) where not selling inventory based on sales projections becomes an issue. Operations relies on sales/marketing for those projections so they know what to build, so it’s not really an operations issue, but a marketing one.

Thanks for exploring this with me Chris! I totally respect your opinion, that’s why I asked.

http://twitter.com/KevenElliff Keven Elliff

Terrific post Chris. While certainly something to track – this one concept seems to terrify business owners I run into any other. Almost from a social competition standpoint (Jane says her ROI is 60% – why is mine only 55%? God I have a problem!!).

Hi Christopher. Excellent post. This is a useful equation for companies looking to put a value to their marketing efforts, and at the same time, your point that this isn’t the only metric to evaluate performance is well received. Regarding offline conversion tracking, I’d like to suggestion another way to effectively capture and record these conversions — call tracking. We actually just published a post (http://www.mongoosemetrics.com/blog/2011/04/12/how-digital-marketing-agencies-can-show-roi/), using your post as a foundation, detailing how call tracking can be integrated in with web analytics and CRM to complete the marketing channel conversion picture. We’d love to hear your thoughts.